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By Karl Domm
Options provide investors with the ability to proactively hedge their portfolios against potential market crashes. In this article, we will discuss the importance of being proactively hedged in an options portfolio.
Why to Hedge?
One of the most critical reasons why it is important to be proactively hedged in an options portfolio is that it is too late to hedge once a market crash has already started.
When a market crash occurs, the prices of stocks plummet, and investors suffer significant losses. The time to hedge your portfolio is before the crash occurs, not after. Proactive hedging involves taking steps to protect your portfolio before the market downturn occurs.
Proactive hedging involves purchasing options that will benefit from a market downturn. These options are typically put options, which give the holder the right to sell an underlying asset at a predetermined price.
When the market crashes, the value of these put options increases, offsetting the losses incurred in the underlying stock. Another reason why it is important to be proactively hedged in an options portfolio is that it can help reduce the overall risk of the portfolio.
By purchasing put options, investors are essentially buying insurance against potential market downturns. While the cost of these options can be significant, they can provide a significant return on investment if a market crash occurs. In essence, proactive hedging is a form of risk management that can help protect investors from significant losses.
Furthermore, proactive hedging can also help investors take advantage of market opportunities. When the market is in a downturn, there are often opportunities to purchase stocks at discounted prices. By hedging their portfolios, investors can protect themselves against losses while still having the capital available to take advantage of these opportunities.
The Collar
There is a well known technique used to be proactively hedged while looking to profit. This technique is called the "collar" strategy.
This strategy involves simultaneously purchasing put options to protect against downside risk while selling call options to generate income. The income generated from selling the call options can be used to finance the purchase of the put options, effectively creating a "collar" around the portfolio.
A collar is a trading strategy that is commonly used to limit the potential loss of an underlying asset while also capping its potential profit. It is created by combining a long position in an asset with a protective put option and a short call option.
While a collar can be an effective way to protect an investor's position in the market, there are several weaknesses to this trade structure. Here are a few examples:
Limited Profit Potential: One of the main weaknesses of a collar is that it limits the potential profit that an investor can make. By using a protective put option and a short call option, the investor is essentially giving up some of their potential gains in exchange for protection against losses. While this may be a smart move in certain market conditions, it can also be a hindrance in others.
Costly to Implement: Another weakness of a collar is that it can be expensive to implement. This is because the investor must pay for both the protective put option and the short call option. Depending on the price of the underlying asset and the specific options being used, this cost can add up quickly.
Requires Active Management: A collar also requires active management in order to be effective. This means that the investor must be constantly monitoring the market and their position in order to make informed decisions about when to adjust the collar. This can be time-consuming and stressful for some investors.
The Alternatives
The collar strategy, while well-known, has some weaknesses that can limit an investor's potential gains and require active management. However, there are lesser-known strategies that can achieve the goal of proactively hedging without these downsides. These advanced techniques involve combining ratio spreads with butterflies and relying on second-order Greeks. As a result, these strategies offer several advantages, including:
Greater Flexibility: These advanced strategies are more flexible than the collar strategy, allowing for more nuanced adjustments to an investor's position in response to changing market conditions.
Lower Cost: These strategies are less expensive to implement than the collar strategy, which can require the purchase of both a protective put option and a short call option.
Potential for Higher Gains: By relying on second-order Greeks and combining ratio spreads with butterflies, these strategies have the potential for higher gains than the collar strategy.
Reduced Need for Active Management: These advanced strategies can require less active management than the collar strategy, which can be a benefit for busy investors or those who prefer a more hands-off approach. While the collar strategy has its place in certain market conditions, there are advanced options trading strategies that can offer several advantages over the collar strategy. These techniques are worth exploring for investors who are interested in proactively hedging their positions while also maximizing their potential gains.
Conclusion
In conclusion, investing in the stock market can be risky and unpredictable, but options trading can provide a way to proactively hedge against potential market crashes.
Being proactively hedged involves taking steps to protect your portfolio before a market downturn occurs. The collar strategy is a well-known technique used for proactively hedging, but it has some weaknesses that can limit an investor's potential gains and require active management. However, there are advanced options trading strategies that can offer greater flexibility, lower cost, potential for higher gains, and reduced need for active management.
Ultimately, investors should consider all options trading strategies to find the one that best suits their risk tolerance, investment goals, and market conditions. By proactively hedging their portfolios, investors can reduce their risk exposure, take advantage of market opportunities, and potentially achieve higher returns.
About the Author: Karl Domm's 29+ years in options trading showcases his ability to trade for a living with a proven track record. His journey began as a retail trader, and after struggling for 23 years, he finally achieved
consistent profitability in 2017 through his own options-only portfolio using quantitative trading strategies.
After he built a proven trading track record, he accepted outside investors. His book, "A Portfolio for All Markets," focuses on option portfolio investing. He earned a BS Degree from Fresno State and currently resides in Clovis, California. You can follow him on YouTube and visit his website real-pl for more insights.
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By Mark Wolfinger
This trader is short two put spreads. One in YHOO (Jul 23/24) and the other in RUT (Jul 920/925). These positions began as iron condors and the calls were covered at a cheap price. "I’m not sure of what I should do. When adding these two positions together, the ‘portfolio’ is too delta long for my comfort zone."
=== RUT ===
I could offset the positive delta of the put-spread by shorting another call-spread. But that is somewhat inconsistent with my belief that I should initiate positions with at least two-months expiry. What would be more consistent is if I closed the put-spread and opened another Iron-Condor with a later expiry. The only thing is that in order to exit at break-even… This is somewhat expected as the volatility conditions for this trade were less than favorable.
Another option would be to roll-down the put-spread. This would reduce the amount of positive-delta, but still leave the portfolio with positive delta. I guess I will be looking to exit the RUT put-spread today. [Note: Position was closed @ 1.20]
My response:
Be careful about measuring portfolio delta. One RUT deltas is much more significant than one YHOO.
a) Delta is the change in value for an option when the underlying moves ONE POINT. One point for YHOO is a big move. One point for RUT is insignificant.
b) The YHOO spread is only one point wide and the max price for the spread is $100
c) The RUT spread is 5 points wide and the max loss is $500 (less credit collected)
d) Delta is a good guide for current (imminent risk), and the risk graph shows how bad things can get when such and such happens. But as to your comfort zone, the RUT position is far more ‘dangerous’ because more cash is at risk and RUT will move many more points than YHOO on almost every trading day.
e) Also consider that RUT is 40 points OTM. I am not suggesting that this is ‘safe’ but the question is: how do you feel about it? If this makes you nervous, yes, do exit. Especially today with a small market bump and a small IV decrease (RVX is -.77 as I write this).
Adjustments
Yes, selling another call spread is a viable adjustment. It is one way to maintain delta neutrality. However, when a trader looks at the current market, it is very difficult to sell call spread now that the DJIA has declined by more than 500 points in the past two days. The ‘best’ time to sell that call spread is immediately after covering your previous short spread. But selling another call spread is not for everyone. This is a difficult decision and I cannot offer guidance. For my trading, I do occasionally sell another spread after covering, but most of the time I do as you did: nothing.
There is a world of difference between initiating positions and adjusting positions.
When initiating a new trade, you have the ability to wait until conditions suit your needs. There is no urgency. You can easily satisfy that need for a minimum of two months.
Adjusting requires a very different mindset. Your objective when adjusting is to reduce risk. NOW. It is not to make more money from the trade. It has nothing to do with future profits. It is only about one thing: recognizing that this trade has gone awry and you want to give yourself the best opportunity to stop the bleeding. Primary goal: make the position less risky, reducing the immediate cash at risk. Secondary goal: Create a position that you want to own (do not blindly adjust and hope for the best) and which gives you a good (this is where your judgement comes into play) chance to make money from THIS POINT. Do not worry about past losses. Do not trade to recover those losses. Trading to get back to even is a losing mindset. Traders make plenty of poor decisions trying to recover losses.
Closing the put spread and opening another iron condor is a good idea. But ONLY when
You do not allow the idea of ‘break even’ to be part of the decision. Please take my word for this. I know what it is like to roll the old position into a new one, choosing the new position based on its price (in other words, paying zero debit or collecting a cash credit for the roll), giving myself the chance to earn my original profit target – if only the new spread would expire worthless. When the market is trending this style of trading is financial suicide. Be willing to take the loss and independently find a suitable new position.
You want to exit the current position because it is not one you want to own.
The new iron condor is one that fits your trading criteria. Far too often traders make this ‘roll’ just to do something. Do not fall into that trap.
You understand that doing this is two separate decisions. Close when you believe that is best. Open a new trade when you find a good one. Do not feel you must open that new trade at the same time the old one is closed. Yes – I know the need to get a new position so you can recover losses. Nothing wrong with wanting that new trade. Just make it a good one and do not allow the thought of getting back your money be part of the decision process. Yes, rolling down the put spread is viable, when two conditions are met.
The cash debit required is not more than you are willing to pay The new position is one that you want to own. The important point of this post is that one YHOO delta is not the same as one RUT delta.
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By Mark Wolfinger
First, it must be understood completely. It may sound trivial, but the trader must know how the strategy works and what must happen to the underlying stock for the trade to make or lose money.
Second, the trader must have confidence that this strategy is appropriate for his/her personality and comfort zone. For example, selling naked straddles (one call and one put, same stock, strike, and expiration) is a higher risk strategy that will appeal only to the most aggressive investor (and it’s likely your broker will not allow you to adopt that strategy). Even iron condor traders cannot just adopt that method in the dark. Strikes chosen and expiration dates play a big part in determining whether the specific trade is acceptable to the individual.
To trade options, it’s obvious that you must begin by buying and/or selling options. The combination of options – whether it’s a single option or a combination of several different series- defines the strategy. Thus, to play the game, you must adopt a position. Thus the strategy is your ticket. It’s your entry onto the playing field. It’s important to be comfortable with the choice, but it is not the only significant factor in your success (or failure). Risk management is more important (in my opinion). If you lose too much at one time, it's going to hurt your long-term results. Be careful and don't allow losses to overwhelm profits.
Selecting one or two preferred option strategies for trading is important because it gives you confidence that your methods can produce profits. There is no point in trading strategies that are recommended to you when you are uncomfortable with any aspect of that strategy. One simple example is the sale of cash-secured naked puts vs. selling put spreads. The former allows for larger profits but involves much more risk. The former is a reasonable play for investors who want to accumulate shares of stock on market declines.
If you don’t care to buy stock and especially if you prefer limited risk strategies, you are not going to be comfortable selling naked puts. If you adopt one of these methods for trading, it’s not that one method is vastly better than the other that should affect which you choose. Instead, it’s which is more compatible with your comfort zone and tolerance for risk. If someone makes good money with a specific strategy, please don’t believe that that strategy makes a good choice for you. Sure, consider that idea, but don’t adopt it just because it works for someone else.
Whichever strategies you decide to trade, your long-term results are going to rely more upon your ability to manage risk than upon which strategy you use. Many traders don’t recognize the importance of risk management until it's too late. By the time they understand that preventing losses is the name of the game, their trading account has been wiped out.
Options were designed to reduce risk. It's unfortunate that far too many rookies begin using options as tools for speculating in the stock market. And it's not only beginners. There's something appealing about using options as a mini-lottery ticket that attracts the attention of all traders. Some can resist, some cannot. As with real lotteries, the odds of success are against the investor who buys a handful of inexpensive, out of the money options, with the expectation that a miracle is at hand. An occasional win keeps them playing. That’s the way a slot machine takes your money. You lose money, make a partial recovery, and continue to play until the money is gone. To repeat: options were invented as risk-reducing tools. They are designed to shift the risk to someone who is paid a premium to accept that risk. There’s no need to minimize risk to the point that profits become unlikely, but there’s also no reason to make long shot plays with little chance of success.
Options are unique in the investment world
Options have specific risks that can be measured. Think about that. When you buy stock, your risk is simply that the stock can move lower, resulting in a monetary loss. But when you own a position that consists of options instead of shares, risk can be identified, quantified, and hedged. That's the subtle beauty of trading with options. When you adopt a specific strategy and make trades to implement that strategy, what you have really done is make an investment whose risk can be managed. When you own stocks the only way to manage risk is to sell some shares.
By understanding the risks, you have the ability to keep them under control. It may feel ‘more risky’ to have a position with specified risk factors – but the truth is that those factors can be reduced by taking appropriate actions - and that makes option trading different and far more effective than buying and selling stock.
What do those Greeks measure? Time decay (theta), exposure to a change in the market volatility (vega), being too long or too short (delta, or share equivalence). If you are familiar with ‘the Greeks’ then these risk factors are already known to you. The Greeks go further. They not only measure the rate at which certain risk factors affect the value of your position, but they also measures the rate at which those factors change (gamma, for example, measures the rate at which delta changes).
Taking the time to understand the Greeks is important, but I consider Greeks to have only one task. They allow you to quantify risk. How much can you expect to earn or lose if the underlying asset moves to this price or if the implied volatility changes by a 10%? Once you quantify risk, the decision becomes: Is that risk acceptable or do you want to hedge (reduce it)? That’s what makes options special.
If you don’t pay attention to managing risk, then you sacrifice the key factor that separates options from all other investments.
Most traders consider choosing a specific option strategy as the key to profitability. They speak of iron condors or selling naked puts as if those words can manufacture profits out of thin air. Only the more experienced trader understands that preventing losses and managing risk is more important.
Most reasonable strategies can produce good results - but market conditions must be appropriate. No one is going to suggest that selling naked puts works in a strong bear market, but if managed well, it can be a winning strategy for investors who like the idea of accumulating stocks whenever the market declines. I no longer sell naked puts, but at one time it represented a good portion of my trading.
Traders argue the merits of their favorite strategy. Which is most efficient for you to trade depends on many factors, including your personality and the effect of psychological factors. For example, see the discussion in Chapter 3 on covered calls vs. an equivalent method, put selling.
Your job, as risk manager for your portfolio, is to prevent those large losses from occurring. Your partner, the trader portion of your persona will try to convince you to relax your restrictions on how much risk should be allowed. Don’t give in. It’s okay to be a bit flexible on occasion, but you must make the final decision regarding risk. Too many traders lose sight of their long term goals when caught up in the excitement of the moment. Maintain your composure and your partnership will be everlasting and fruitful.
Bottom line: Choose a trading strategy that makes you comfortable, but manage risk carefully.
Choosing the ‘best’ strategy is not your objective.
The strategy does not make money The strategy is merely your method of playing the game The strategy tells you which options to buy and sell Risk Management tells you
How many options to buy and sell (position size) When to buy and sell them When to take your profit When to adjust or exit the trade In other words, risk management tells you how and when to control risk to be certain you don’t incur large losses.
This post was presented by Mark Wolfinger and is an extract from his book Lessons of a Lifetime. You can buy the book at Amazon. Mark has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Mark has published seven books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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Trader Mindsets How Much Can I Earn With Options? Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Learn First. Trade Later Adaptability And Discipline Maybe The Market Will Turn Around Trader’s Mindset: Always Collect Cash The Art Of Trading Decisions Managing Risk For More Than One Position My Philosophy On Options Education Trade Decisions: Risk Or Profits?
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By Kim
In fact, options combined with the traditional buy and hold method can produce excellent returns, and it is about time investors who are not in the know, learn how to use them. I question, will you make more in a trade by hedging? The answer is no, but you won't lose as much on the investments you are wrong about. An investor who knows how to use options to hedge investments is an investor who has an edge on ones that are too ignorant, or just can't cleanse themselves of the current negative stigma that options have.
So what exactly is a hedge?
Hedging with options is essentially reducing risk. You are entering a position that offsets your current investment, protecting you from potential drastic price movements. We hedge all the time in our everyday lives. When you purchase a brand new vehicle, you're not going to drive it on the highway without auto insurance. Lets forget about the legality of driving without insurance and just think about you potentially exposing your money, or the cost of the vehicle, to a drastic change such as a potential accident. When you purchase auto insurance, you are hedging against an accident. You may drive for 50 years without a single insurance claim, but at least you were covered if the worst were to happen.
How can I hedge with options?
Many options skeptics believe that with careful research and fundamental analysis there should be no reason to hedge a stock with an options contract. If you don't know about the “dot com bubble” of the early 2000's, I highly encourage you to Google it. It is fairly safe to say that although there was an abundance of ill-informed people investing at that time, there were some that did their homework and still lost. These investors could have saved their portfolios had they hedged their investments.
Lets go over some ways you can use puts and calls to hedge. For simplicities sake, during these examples we will not be including the premium it costs to buy these options. The premium paid is not a static number and the price paid depends on how comfortable the investor is with the underlying security.
Hedging with put options
Lets say you're currently bullish on stocks in the oil and gas industry. You are long 100 shares of IMO(Imperial Oil) at $44.75 and although you are still comfortable owning them, you believe with the way the industry is going you need to protect yourself from a potential downfall. The easiest way to do this is to simply purchase a put option. As you probably already know, a put option gives you the right but not the obligation to sell 100 shares of the specific underlying security at the strike price. Lets go over a couple examples and explain how you can hedge with a put option.
Scenario 1: You decide not to hedge against a potential decline of Imperial Oil and the stock drops to 30 dollars over the next couple months. Fearing an even bigger decline, you decide to sell your stocks and you suffer a $14.75 loss per share, or $1475 total.
Scenario 2: You decide to hedge against the downfall, and purchase a put on IMO. You purchase a put that expires 6 months from now, with a strike price of 38. You now don't have to worry about a potential decline to 30 dollars a share, because your put gives you the right to sell your shares at any time within the next 6 months if the stock falls below 38. Lets say at expiration the stock sits at 30 dollars. You exercise your option and sell your shares at $38, eight dollars over market value, collecting $3800. Your loss is now $675 ($4475 - $3800), less the premium paid. This is less than half the amount you would have lost if you had decided not to hedge.
Hedging with call options
Hedging with call options is not as popular as puts. The reason being that this is when you hedge with a call, it means you are short the position. A lot of investors are not comfortable with short sales or do not have the ability to short depending on their account types. Lets go over a situation where you could hedge your short sale to prevent large losses. Please note that the extra costs involved with short selling such as interest are not considered.
You're currently bearish on stocks in the oil and gas industry. You believe that with the fall of oil, industry margins will decline and profits will decrease. You decide this is a good time to short 100 shares of IMO at $44.75 a share. You borrow the shares from your broker, sell them and your account is credited $4475.
Situation 1: You decide not to hedge your short, and over the next couple months IMO heads to $55 a share. You are worried the stock will go even higher and are forced to purchase the shares to give back to your broker. You end up paying $5500 dollars for these shares and suffer a $1025 loss.
Situation 2: You decide to hedge against an upward swing of the stock and purchase a call option on IMO. You are comfortable with paying $2.25 more on your shares if IMO takes a turn in the wrong direction and purchase a call with a $47 strike price. IMO sits at $55 dollars at expiration. Instead of buying the shares from the open market, you simply exercise your option to purchase the shares at $47 and close the short position with your broker. Your total loss in this situation is $225 dollars. The hedge saved this investor $800 less the premium paid.
The cost to hedge
Remember that when you are purchasing an options contract, it comes with a premium. If your car is worth $500 dollars, it probably doesn't make sense to pay an extra $70 dollars a month for collision insurance does it? You have to find a balance between the premium you're paying for your options and the level of protection you have.This ensures that when your option expires useless, you weren't paying a fortune to hedge. Keep in mind that options are a time wasting asset. The longer your expiration date is away, the more time premium you will pay. An option that expires in a year has much more value than an option that expires in a month.Hedging with options more often than not will include long-term options, so you will be paying a higher premium. Make sure you calculate these premium costs and make sure you aren't paying a fortune for your insurance.
Conclusion
Options are one of the most versatile investment vehicles you can use. Hedging with options is a crucial strategy that every buy and hold investor should have in his toolkit. The stock market is filled with surprises, and not hedging against them is exposing you to potential risk. An investor that is so confident with his investments that he doesn't feel the need to hedge them will soon be hit with a hard dose of reality. Does hedging make sense with every investment? Of course not! A day trader who expects to make small amounts of profit over a large amount of trades may not find it appealing to hedge his investments. But for most, hedging can be beneficial, and be reminded that greed and lack of knowledge are two of the various reasons investors go broke. Don't risk a large chunk of your portfolio just due to you didn't want to pay a small premium to protect yourself.
This is a guest post by Stocktrades, an investing website focusing on teaching new and intermediate investors the intricacies of the market. Learn how to trade options by following Dan's options blog. You can also follow them on Twitter StockTrades_CA.
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By Drew Hilleshiem
However, today, we’ll focus on ways to take risk off your stock positions (or transfer it to other risk). This may be a stock you chose to own, or perhaps a stock you were assigned when a premium selling trade went against you. Therefore, we’ll evaluate these setups both through the lens of hedging as well as repairing a losing position that was assigned to us.
We will discuss several strategies and the tradeoffs when executing.It is important to note (and hopefully it goes without saying) that there’s no free lunch in trading.
We will also use real options examples and pricing from EWZ, the Brazilian Emerging Markets ETF with July 20, 2018 expirations for all contracts. At the time of writing, EWZ is demonstrating fairly high implied volatility rank and good liquidity.
Our game plan will be to briefly cover 3basic strategies as a fundamentals review and for sake of comparison against 2 strategies that are a little more advanced but unlock a lot of power for hedging. That is, if you can handle the tradeoffs and additional capital outlay when things go wrong.
The three basic strategies we will cover are:
Covered Call –the sale of a call for income to reduce a stock’s cost basis. Protective Put –the purchase of a call as protection against a price decline; and, Collared Stock –the sale of a call and the purchase of a put, a combination of sorts of the covered call and protective put. However, the focus of this article will be on these advanced strategies:
Front Ratios–A Call Front Ratio involves either buying 1 call ATM and selling 2 calls OTMfor a net credit or slight debit (depending on the premium paid/received – see below for more). APut Front Ratio with Puts involves selling 2 puts OTM in order to finance the purchase of 1 put ATM. Double Front Ratio–involves the execution of a Front Ratio with Calls& Puts simultaneously against a stock position of equal shares. This setup offers a way to double your profits up to a limit (i.e. the short call in the case of a Front Ratio with Calls that creates a net credit) while also protecting against downside or upside risk.
Strategy #1: Covered Call – Used to Reduce Risk and Reduce Cost Basis
Covered Calls are the most common ‘partial hedge’ used by traders.Here is the setup:
You sell a call against an existing stock position creating a net credit.
You use the Covered Calls to create additional income and increase the overall return on the stock. This provides small ‘cushion’ against a short term drop in the price of the underlying stock.
You purchased EWZ at $38.10 and sell a $40 BHGE call for $0.85. Here’s your position:
Long 100 sh. EWZ @$38.10 = $3,810
Short 1 EWZ40 Call @$0.85 = ($ 85)
Total outlay $3,725
Max gain: Strike price ($40) – Stock price ($38.10) + premium received ($0.85) = $2.75 × 100 = $275;
Max loss: Stock price($38.10) – premium received ($0.85) = $37.25 × 100 = $3,725 (if Brazil ceases to exist in less than two months’ time.);
Breakeven: Stock price ($38.10) – premium received ($0.85) = $37.25
Risk Plot:
EWZ Covered Call
This options setup is popular with traders as it lowersyour cost basis, and can be repeated with time for income or to ‘repair’ a position, in the event that you were assigned stock from a short put position.
…but you’ve probably already traded this.
Strategy #2: Protective Put–Really Expensive Downside Protection
A Protective Put is a bearish hedging strategy that involves the purchase of a put against a portfolio position and fully covers you against a catastrophic loss (no Brazil in 2 months).The setup is as follows:
You buy a put against an existing stock position creating a net debit.
This options setup makes sense if the stock takes a sharp decline during the contract’s life. Honestly, I never understood this position for retail traders. If you expect a large decline, why not just sell your stock?
You purchased EWZ at $38.10 and purchase a $38.10EWZ put for $1.85. Here’s your position:
Long 100 sh. EWZ @$38.10 = $3,810
Long 1 EWZ38Put @$1.85 = $185
Total outlay $3,995
Max gain: unlimited upside (once you have passed the breakeven point below as your cost basis has increased);
Max loss: Stock price ($38.10) – Strike price ($38) – premium paid ($1.85) = $1.95× 100 = $195; Breakeven: Stock price ($38.10) + premium paid ($1.85) = $39.95 × 100 = $3,995.
The most you lose in this setup is $195for the next 2 months, because ifEWZ continues its decline toward $0, you can “put” the stock at $38 (prior to expiration), limiting your loss to the difference between your total outlay and what you receive for the sale of the stock at the put’s strike price.
All sounds nice, but no one hedges like this. If you do – please stop. $185 for insurance is paying nearly 5% per every two months for protection. Good way to go broke slowly.
Risk Plot:
EWZ Protective Put
Strategy #3: Collared Stock– Used to Create Upside Opportunities and Limit Downside Risk
A Collared Stock hedge provides trading upside for limited downside protection. The setup for a Collared Stock hedge is:
You sell a call against an existing stock position creating a net credit and simultaneously buy a put.
You purchased EWZ at $38.10, sell a $40 BHGE call for $0.85 and purchase a $35EWZ put at $0.75. Here’s your position:
Long 100 sh. EWZ @$38.10 = $3,810
Long 1 EWZ35 Put @$0.75 = $75
Short 1 EWZ 40 Call @$0.85 = ($ 85)
Total outlay $3,800
Max gain: Strike price of Call ($40) – Stock price ($38.10) – net premium (-$0.10) = $2 × 100 = $200;
Max loss: Stock price ($38.10) – Strike price of Put ($35) + net premium (-$0.10) = $3 × 100 = $300;
Breakeven:Stock price ($38.10) + net premium (-$0.10) = $38 × 100 = $38.00.
The collar gives you a chance to gain in the above example up to $200 (up to expiration; unlimited after the options expired as the stock price climbs) on the upside and limits loss on the downside to $300. Limited gain, limited risk, a good setup for risk mitigation and certainly much smarter to finance your put protection with the premium from selling the upside call.
Risk Plot:
EWZ Collared Stock
Strategies 1, 2, and 3 are basic options setups that are likely familiar to you and well utilized (hence the summary review).
If you’re still with me, I promise it’s going to get more interesting. The next strategies are more advanced, but will offer clear benefits (with tradeoffs) compared to those we already looked at in our quick review.
We will now spend the bulk of our time discussing the Front Ratio and Double Front Ratio options setups. We’ll spend a little time on these (in a slightly different format than the above examples), with illustrated examples to show how they are designed.
Strategy #4: Front Ratio–Used to Protect Against Downside Risk (with Puts) or Upside Risk (for short positions with Calls)
A Front Ratio provides either downside risk protection (in the case of a Put Front Ratio) or upside risk protection (in the case of a Call Front Ratio).
How you choose to deploy this strategy depends on the setup you choose. Here are the setups for a net credit Front Ratio with a Call/Put:
You buy 1 ATM Call (first strike price) and sell 2 OTM Call (second strike or skipping strikes so long as you create a net credit).
Let’s look at the position for a Call Front Ratio and the associated risk plot to better understand the mechanics.
Long 1 EWZ38Call @$1.71 = $171
Short 2EWZ 40 Call @$0.88 = ($176)
Total CREDIT $5
EWZ Front Call Ratio w/o Stock
The Front Ratio with Call is a moderately bullish outlook. You want the stock price to move to that of the second strike price (exactly) at expiration and collect the net premium as your profit.
The problem with this position is the naked call. Since there is no limit to what EWZ can appreciate to, there is also no limit to the potential losses. It gets interesting, however, when paired with the underlying stock.
EWZ Front Call Ratio Paired with EWZ Stock
You might be thinking: “Drew, this isn’t a hedge.”. You are absolutely right; but I believe it’s worth discussing for a few reasons.
It is a building block for the end setup, which is a great hedge. Many times options traders are put in the position of hedging a stock that has gone against them. We’re in essence trying to ‘repair’ the position, while limiting further directional risk. What’s interesting about this setup is that we have 2x profits up to the short call. Imagine a scenario where we were short the $43 puts in a prior expiration cycle that we sold for $1. Our break even is now $42/share. If the stock recovers to $42/share, we have broken even on a bad trade. Great outcome, but not very probable.
Now, if we were willing to trade upside for an embedded call vertical (front call ratio) we can break even at $40/share instead of $42. Nice tradeoff.
For the Put Front Ratio, I’ll explain it backwards to ensure you understand. You sell2OTM Putsin order to finance the purchase of1ATM Putwhile still creating a net credit.
Let’s take a deeper look at our position and risk graph in this setup:
Long 1 EWZ38Put @$1.80 = $180
Short 2EWZ36Put @$1.00= ($200)
Total CREDIT $20
EWZ Front Put Ratio Paired w/o EWZ Stock
The Front Ratio with Put conversely is moderately bearish, where you expect a dip in the stock price. In this case, the stock price must reach the first strike price (exactly) at expiration for profit to occur. Please note that this is an advanced setup – you should have a good grasp on the greeks and trade small when trying out for the first (and every time).
However, this is a hedging article. So let’s look at this setup paired with stock.
EWZ Front Put Ratio Paired with EWZ Stock
I hope the wheels are turning here. A Front Put Ratio paired with stock gives you $2 of
directional protection without paying a premium (on the contrary, we’re paid $0.20) and without sacrificing upside potential. Wait – “no free lunch”, remember?
There is a major tradeoff here. We’re promising to buy more stock if the price continues to fall. This doubles the rate of our losses. Alarm bells may be ringing, and it isn’t for everyone. In the end, I’ll give you my take on when this could work. In the meantime, and in case you drop off here, I would urge you to only consider this if you are long-term bullish on the stock. In effect, it’s a form of dollar cost averaging.
If you’re still with me, you might be thinking “why not combine the two?”. Well, good idea. Let me present Strategy #5.
Strategy #5: Double Front Ratio–Hedging and Getting Back to Even
This “hedging” or “repair” strategy involves a simultaneous Call/Put Front Ratio.
Let’s break down what we’re doing here in slightly different terms. We’re taking immediate directional risk off with a long put vertical, which is financed with another short put. This increasesour notional risk but lowers our probability of loss.
We’re also trading our ‘unlimited upside’ from the long stock by deploying a covered call. The premium from the covered call is used to finance a long vertical call spread, which doubles our profit for immediate price moves.
Instead of painstaking recycling the individual contracts from above. Let’s review the equivalent position:
· 1 Covered Call (defined risk, limited upside),
· 1 Bear Put Spread (defined risk, financed),
· 1 Short Put (a promise to buy more, but defined risk), and
· 1 Bull Call Spread (defined risk, financed)
Let’s look first at the risk plot for the options-only position, as before:
EWZ Double Front Ratio w/o EWZ Stock
A few comments on the naked stock position. The profit range is huge. We see profits so long as EWZ remains between 33.75 and 42.25. Options trading models estimate an 82% chance of that happening at current volatility. Expansions in volatility hurt the position and probabilities while contractions in volatility benefit the position.
The volatility effects are interesting in terms of repairing as we often put these structures on in high volatility environments as we see price movements beyond our anticipated levels from the failed short position.
Now, let’s look at one of the strangest risk plots you may ever see. Let’s pair the options up with the stock position.
EWZ Double Front Ratio Paired with EWZ Stock
With a Double Front Ratio as a hedging or repair strategy,if the stock recovers you make $2 for every $1 move in the stock up to the short call. If you are repairing a position, this allows you to lower your break-even strike.
To the downside, you are protected dollar for dollar up to the short puts. At this point, you are committed to buy more or roll down and out if unassigned. Volatility will also likely expand, which is great for rolling so long as the stock doesn’t blow through your short strikes.
When compared against the introductory hedging options at the beginning of the article, you can see how powerful these setups are, but here’s a word of caution: it isn't for everyone. This reinforces our contention that you should always trade small (consistent small trades yield consistent small profits).
When I look at income candidates, I decide what position size I want and then divide by 4. This allows me to do such a hedge/repair twice before reaching my intended allocation. It takes discipline, patience and a lot of trades.
I understand that even introducing such an idea may be considered “controversial”to conventional trading wisdom. However, let me argue that most of the adage of "don't add to losers" is sound advice rooted in a bad habit of over-allocated positions at trade entry!
The last point is that you can also put on these setups when purchasing the stock (similar to a buy-write). If you put on a Double Front Ratio at the time of purchasing the stock, you usually have more downside protection than a covered call and you have double profits compared to a covered call.
Extra Credit:
Expanding on the topic and potential fodder for a future article, can anyone describe what was done in this risk graph? Hint: it’s paired with EWZ stock and can also be used as a partial hedge.
Drew Hilleshiem is the Co-Founder and CEO of OptionAutomator, an options trading technology startup offering a free options screener that leverages Multi-Criteria Decision Making (MCDM) algorithms to force-rank relevancy of daily options opportunities against user’s individual trading criteria. He is passionate to help close the gap between Wall Street and Main Street with both technology and blogging. You can follow Drew via @OptionAutomator on Twitter.
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By Kim
This is sad, because without a suitable size for the positions any method of negotiation will be incomplete.
Many people avoid monetary and risk management issues because they realize that controlling risk will not get rich. But the fact is that you will not get rich at all if you do not learn how to manage money.
One of the pillars of the industry is the search for the holy grail and in fact the industry is in love with the trading systems. Many traders, especially those who go through that initial phase of frustrating losses, are looking for mechanized trading methods that simply generate input and output signals to follow without asking questions. However, they rarely seek a "monetary management system" capable of generating clear "signals" about how to adjust and manage the size of positions. But the reality is that these techniques exist and, despite being mechanical, are much more effective than the signal generators of buying and selling.
Have you ever considered the following: If money is earned through trading systems, why do the vast majority of traders end up without profits or losing money? This is not due to the lack of consistency of forecast resources or services that are available for every trader. This is due to monetary management, which is practically a last minute idea for many traders.
Just Bad Luck or an Immutable Mathematical Law?
Let us now turn to the playing field of the negotiation: here, the percentage of Winning Operations and Profitability can vary with the change of market conditions. The only parameter that the trader can effectively change is the risk.
We will use the example of the launching of a coin to present some fundamental concepts of risk management. When we flip a coin, our luck is equal to a 50% winning transaction percentage. The risk is the amount of money that we play, and therefore put at risk, on the next release based on the payment ratio. In our example, our "luck" and our payment remain constant.
Following the example of coin tossing, it does not matter in what order the faces and crosses appear. If we first take 50 crosses and then 50 faces, the result would be the same as if we took 50 faces and then 50 crosses.
In options trading, the order of the operations that are performed, as well as the result of any operation are almost always random. Therefore, from a risk control perspective, it is not advisable to stick to or emotionally the result of an operation or a series of operations, nor financially risking too much.
To understand that what appears to be an unlikely outcome is, in fact, possible we need the help of the Law of The Large Numbers.
The Large Numbers Law tells us that a random event is not influenced by previous events. This explains why the percentage of Winning Operations in a system does not increase even if the system has recorded 20 consecutive losses. While it is true that recent operations affect the overall percentage of Winning Operations, many operators enter the market thinking that a corrective move should occur, simply because they have had several consecutive winning or losing trades. In doing so, they are expressing the belief in the so-called "gambler’s fallacy".
This brings us to the next point: imagine that you think you are unlucky after a really bad loss streak when it seemed like you had found a winning system. If there was a way to know how long a streak will last …
Well, if you know the probability of an event (percentage of Winning Operations) and how many times the event will take place, there is a mathematical formula that will indicate the maximum number of winning and losing streaks. But in trading the number of times the event occurs is not known, since it can cover your entire life as a trader.
If we knew the number of operations that you will perform during your life, you could calculate the maximum number of consecutive losses, provided that the percentage of Winning Operations remains exactly the same. By varying the percentage of Winning Operations, the number of consecutive losses will improve or worsen. But it is impossible to know both numbers in advance.
The Ralph Vince Experiment
Ralph Vince conducted an experiment with 40 doctorates without previous training in statistics or trading, which were given a simulated computer trading environment. Each of them started with $ 1,000, a percentage of Winning Operations of 60% and they were given 100 transactions with an Expected Payment of 1:1.
At the end of 100 tests, the results were tabulated and only two of them earned money. 95% of them lost money in a game in which the odds were in their favor. Why? The reason they lost was the belief in the gambler's fallacy and the resulting poor monetary management. Greed and fear were used to calibrate operations.
The aim of the study was to demonstrate how our psychological skills and our beliefs about random phenomena are the reason why at least 90% of people who have just reached the market lose their accounts. After a series of losses, you tend to increase the size of the bet by believing that a winning operation is now more likely - that is the gambler's fallacy, since the odds of winning are still 60%.
If you want to learn how to treat options trading as a business and put probabilities in your favor, I invite you to join us.
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